Thursday, June 07, 2007

Dollar weakness and oil producing countries

"Oil producers in the Gulf not only price their one commodity (oil) in dollars, but their currencies for the most part are dollar-pegged and, largely as a result, their foreign exchange reserves are massively overweight dollars. In a high oil price environment, the more the United States relies on external lenders to fund its saving-short economy, the more the Gulf region fills the void – and increases its dollar-concentration risk accordingly. This outcome does not sit well with asset allocators in the Middle East. In fact, in my two most recent visits to the region in early 2007, I detected a growing unease with these concerns. The region worries increasingly about excessive exposure to a chronically weak dollar scenario as an unavoidable outgrowth of a prolonged US current account adjustment. Nor is this situation stable. The longer the US suppresses its domestic saving, the greater the risks the Gulf region may face as a levered play on the dollar. Kuwait’s just announced decision to end its dollar-pegged currency regime may well be the first step in a regional diversification strategy that attempts to temper such risks."

Moving some portion of oil revenues out of dollar-based investments and into other countries is a logical move at this point for oil exporters. However, the types of investments that are made with these funds is a key variable. Just putting the money into sovereign debt wouldn't be that productive. Finding projects in emerging markets that can generate decent rates of return is the core issue...

Update: Well, I have to back up and say that if the US yield curve returns to a meaningful upward slope as it might be on its way towards based on today's market activity, all of the above becomes somewhat less relevant. If long-dated Treasury yields jump up quite a bit, that will goose the value of the dollar upward as well, obviously. Then the oil producers' problem is solved. Recent Treasury auctions have been weak anyway...